Achieving global decarbonisation targets will require renewable electrification of processes that currently rely on fossil fuels. However, certain sectors—such as aviation, shipping, concrete and steel manufacturing—have energy needs, such as energy density and heat levels, that cannot easily be met through electrification. Low-carbon hydrogen holds significant promise for these sectors as a low-carbon alternative.
The economics of low-carbon hydrogen are challenging today, primarily because of the underlying costs and availability of renewable energy and carbon capture, utilisation and storage (CCUS). Recognising the promise of low-carbon hydrogen and the economic challenges it faces, jurisdictions across the world are implementing strategies to address these issues and accelerate the development of a low-carbon hydrogen industry.
These strategies need to take into account a range of different considerations. One such consideration is the establishment of tax policies that will incentivise investment in both demand and supply side infrastructure. In most jurisdictions, low-carbon hydrogen strategies are in their infancy, with limited development of specific hydrogen tax policies. However, in the near term, we expect to see a range of tax policies introduced, aimed at promoting the establishment of a low-carbon hydrogen industry.
Relevant tax policies are likely to include:
- Carbon pricing
- Accelerated deductions for capital
- Transferable tax credits
- Refundable tax credits
Each of these have been considered in further detail below.
Carbon pricing/emissions trading scheme
In the medium term, pricing carbon emissions is likely to be the core mechanism governments use to incentivise a shift to lower-carbon technologies, including low-carbon hydrogen.
Sixty-four jurisdictions (including subnational jurisdictions such as the US state of California and British Columbia in Canada) have implemented carbon pricing regimes, according to the WTO's Carbon Pricing Dashboard. Of these, 35 have implemented carbon tax regimes and 29 have established emission trading schemes (ETS).
Carbon pricing is considered an efficient, technology agnostic mechanism for reducing greenhouse gas (GHG) emissions. However, unilateral implementation of aggressive carbon pricing strategies can result in “carbon leakage”, where high-emitting industries shift to jurisdictions which do not have carbon pricing mechanisms.
To address this leakage, the EU is proposing to introduce a Carbon Border Adjustment Mechanism (CBAM). If adopted, the CBAM will impose a levy on the embedded carbon in imports in carbon-intensive sectors like steel, cement and electricity.
As an alternative, the IMF is promoting an International Carbon Price Floor that would initially set a minimum price for carbon that would be adopted by a small number of high-emitting jurisdictions.
The IMF considers such an approach to be more efficient and effective than carbon border adjustment mechanisms in achieving emissions reductions and limiting carbon leakage, as the border adjustment mechanisms are complex to apply administratively, apply only to a small portion of a trading partner’s emissions and are at risk of being challenged under World Trade Organization (WTO) rules, the IMF wrote in a recent report.
Despite broad effectiveness at incentivising a shift to low-carbon technologies, it has been recognised that a carbon price alone may not be sufficient to support the pace of technological innovation required to meet global carbon targets. This is relevant in the context of low-carbon hydrogen, which continues to be significantly more expensive than traditional fossil fuel solutions even when a carbon price is factored in. Consequently, additional tax policies beyond a carbon price are likely to be required if jurisdictions are to effectively incentivise investment.
Establishment of a low-carbon hydrogen industry will involve significant capital investment. The ability to claim accelerated or immediate tax deductions for such capital spend can significantly enhance the return for investors by deferring the timing of tax payments until at least such point that the capital investment has been fully recovered.
While such incentives can be effective at encouraging investment in more mature industries, the impact for investment in new fledgling technologies can be less pronounced given the higher risk profile of those investments. For these higher-risk investments, there is a higher chance that the benefit of the accelerated deduction will never be realised because the project never achieves sufficient profitability. In these circumstances, increased certainty around the ability to “monetise” the tax deductions generated by these capital investments can be more important than the immediate deduction itself.
The ability to monetise credits may be enhanced through schemes which allow for tax deductions (or credits) to be transferred to investors or other parties who are better able to benefit from those tax deductions.
For example, the US has established a Section 45Q tax credit to encourage the construction of CCUS facilities. These tax credits are able to be transferred from the upstream carbon-capture equipment owners to others in the supply chain who may be able to derive more benefit from the tax credits (i.e. transferred to downstream operators who sequester the carbon or use it for conversion into usable products etc), according to the Energy Futures Initiative. Such transfers enhance the cost-effectiveness of the product supplied by the upstream carbon-capture equipment owners.
In Canada and Australia, there are rules that allow tax deductions associated with expenditure on mineral exploration programmes to “flow through” from the exploration company to the company's shareholders, who are able to utilise those deductions to offset income from other investments. This ability to transfer tax deductions can significantly de-risk investments, encouraging broader access to capital, particularly for startup organisations which are often the source of technological innovation.
Such transfer policies are likely to be considered in the context of encouraging low carbon hydrogen projects, particularly in the early stages of development.
An additional step in the context of “monetisation” of tax deductions is to provide for refundable cash credits for particular expenditure, effectively “cashing out” the value of future tax deductions either at the current tax rate or at a premium to the tax rate.
An example of this is the cash credit provided in Australia for particular research and development (R&D) expenditure. Broadly, for income years commencing on or after 1 July 2021, eligible businesses with an aggregated turnover of less than A$20mn ($15mn) are entitled to a refundable R&D tax offset equivalent to their company tax rate plus an 18.5pc premium. If the tax offset exceeds the entity’s tax liability, the balance is paid to the entity in cash.
This form of cash credit acts as a significant incentive for taxpayers otherwise unable to realise the benefit of tax deductions associated with their expenditure. It provides a source of cashflows that can be “banked” by smaller organisations, which can then be reallocated into additional R&D activities.
Given the significant technological innovation that will be required in order for low-carbon hydrogen to compete with existing technologies, we expect refundable R&D schemes and potentially broader tax refund arrangements will be a core plank of the tax policy supporting a low-carbon hydrogen future.
Summary and conclusion
This paper provides an example of tax policies that can be used to incentivise investment in low-carbon hydrogen solutions. Governments globally must determine which policy levers are most suited to incentivise the establishment and growth of a low-carbon hydrogen economy. For the reasons set out above, this will likely require a combination of a number of tax policies, which can be adapted to meet the different needs/tax profiles of different classes of investors.
James O'Reilly is partner, global EU&R tax leader, and Michelle Plattner is senior manager, global EU&R tax driver, at PwC